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FHLB-Chicago Skating on Very Thin Ice

Posted by Larry Doyle on August 5, 2009 4:21 PM |

The Federal Home Loan Bank (FHLB) system represents significant risks within our financial system. The fact that you do not hear about this system does not mean the risks are shallow or insignificant. You do not hear about the FHLB system simply because the general media pays no attention to it. They should.

Thanks to a close friend for sharing a recent FHLB-Chicago Presentation. This overview provides the following:

1. market update
2. financial results
3. developments in products, credit, and collateral
4. future outlook

Based on my experience, the FHLB-Chicago was always one of the more conservatively managed banks within the FHLB system. That said, after reviewing their financials it is very apparent that this bank is skating on very thin ice and if not for the relaxation of the mark-to-market by the FASB would be well below regulatory capital standards.

For those intrigued by the inner workings of a FHLB, this review provides riveting details. If you are looking for the Cliff Notes, allow me to highlight:

Pages 27-28
The Net Income Statement for ytd 2009 and comparable period in 2008 displays the enormous benefit of the relaxation of the mark-to-market accounting standard as the bank swings from a $152 million loss in 2008 to a $64million gain for ytd 2009.

Pages 35-36
The regulatory capital ratios for FHLB-Chicago highlight that this entity has approximately a mere $200 million in excess capital above the minimum requirement. For an entity this size, $200 million is razor thin.

Page 39
impairment of this bank’s assets is truly mind boggling. As of year end 2007, the FHLB-Chicago viewed 100% of their assets as being AAA. Fast forward a mere 18 months, now 35% of these assets are rated CCC or worse. Please review the graph on this page for a hint as to the destructive nature of these ratings downgrades on this bank. FHLB-Chicago is representative of many financial entities in our banking system today. No surprise why so many are failing and will continue to fail. This graph is very powerful.  What do you think the bid is for that CCC bucket of assets right now? Zero or very close.

Page 40
The FHLB-Chicago highlights that they have taken writedowns of $263 million on their assets due to credit impairments while they still view potential writedowns of $1.213 billion on these assets due to market conditions.

Given that the FHLB-Chicago admittedly has a mere $200 million in excess capital to satisfy the minimum regulatory capital ratio, we can see that without the relaxation of the mark-to-market they would be woefully capital deficient.

Is the housing market going to improve markedly so that their assets will dramatically increase in value, especially that 35% in the CCC bucket? I would not bet on it.

. . . and the FHLB-Chicago is one of the better managed.


Related Sense on Cents Commentary

Freddie Mac, Fannie Mae Deja Vu?; May 28, 2009

  • Aaron Kramer

    This is without a doubt the next shoe to drop. These entities are on the verge of insolvency and very few people know it. When Freddie and Fannie collapsed Bush and Congress made the FHLB the holding companies for every mortgage they could find in order to prop up the market. These institutions were improperly used to support the mortgage market over the last 18 months and they were never designed to operate in this capacity.

  • Aaron Kramer

    The more I think about this topic the angrier I get because this is exactly why all citizens should fear anything labeled “URGENT GOVERNMENT ACTION.” The repercussions are often worse than the original problem and now we collectively own the debt. I wish people would stop and think but alas politics seems to rule every decision we make and that does not bode well for the future.

  • Petricone456

    LD – Thanks for pointing this out!!!

    But, I just want to say to everyone there is no need to worry. Did you see today’s top performers in the equity market? None other than goverment darlings Fannie Mae(+37%), Freddie Mac (+34%), and AIG (+61%). All is well again.

    In all seriousness, the powers that be will probably look the other way and let the FHLB Chicago and all the other FHLBs run below minimum capital levels. As LD noted, the media pays no attention to the FHLBs and I’m sure the FHLBs would like to keep it that way. At a well known community banking conference held last week, a regional bank in Texas noted that during the SNL crisis Federal regulators knowingly let the bank run below minimum capital levels. In no way am I saying this is how regulators handle all troubled financial institutions, but I am saying this would not be the first time watch dogs have looked the other way during a financial crisis.

    Here’s a link to a January ’09 article from SeekingAlpha that contemplates FHLB bailouts:

    • Larry Doyle

      Great color. I am willing to bet that AIG and Freddie/Fannie will most likely execute a debt for equity swap with Uncle Sam so their debt burdens are lessened.

      What does that mean? Uncle Sam, that is you and me folks, are moving even lower in the capital structure. This will be more of a cosmetic move than anything else. I view it as another indication of problems at these organizations. What would those problems be? They are not generating enough cash flow to service interest and preferred dividend payments.

  • divvytrader

    hey LD …… here’s the real ‘Chicago Way’ ………

  • coe

    Sorry for the late response, but I couldn’t leave this stone unturned. From my perspective, the Chicago District Bank story is a lesson in what goes wrong when zealotry supercedes common sense. Specifically, recall that it is in the Windy City that the FHLB system hatched their ill-designed plan to compete with Freddie and Fannie by creating the MPF program a dozen years ago. Tens of bllions of dollars later, these loans remain a drag – both because of funding and risk management pressures and because of the lack of a securitized take-out – and this alco challenge is only exacerbated by declining market values. So reasonable people can debate the quality of good vs bad management here. Secondly, if you look closely, the sad fact is that a number of the districts – particularly those exposed to these mortgage purchase programs and/or to large non-agency positions in their investment portfolios – have essentially “broken the buck” in terms of their true value of economic capital. How can member banks redeem their stock at par, when the institution is effectively “below par” on a risk adjusted footing? Truth is that is yet another reason why consolidation across districts may be pert near impossible – especially when you think of the system’s “joint and several” status.
    I think you are right to keep pointing a flashlight under the covers here, LD. My last thought/parting shot is that in the infinite wisdom of government regulatory reform, the administration decided to disband the FHFB and lump the Federal Home Loan Banks under the umbrella of the FHFA with their kissin’ cousins – Freddie and Fannie! Who do you think will get the attention? I really don’t think it will be the Home Loan Bank of Des Moines! And who is on their supervisory board – that’s right, the Director of FHFA, who acts as chair, accompanied by the Secretaries of HUD and the Treasury, and the Director of the SEC – gulp! Don’t these folks already have enough to do, and aren’t they already more than challenged to attend to the rest of their knitting! Somehow, some way…we have to figure out a way to improve the “leadership” of America – certainly at the operating and Board levels in business, not to mention the political process…enjoy the weekend at the beach, LD!

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